10 min readConcept sheetOften a 5-mark answer or a 10-mark comparison essay

Monopolistic competition and oligopoly

Monopolistic competition has many firms with differentiated products; oligopoly has a few large, interdependent firms that watch each other's every move.

Monopolistic competitionMany firms, branded products, free entry

Its long runNormal profit with excess capacity

OligopolyFew firms, high barriers, interdependence

Oligopoly behaviourPrice rigidity, collusion, non-price competition

Two imperfect markets

Monopolistic competitionMany sellers, each with a differentiated product (brand, location, service, design). Each firm has a little price-setting power, so its demand curve slopes down but is fairly elastic. Free entry and exit. Firms compete through advertising and branding. Examples: restaurants, salons, bakeries and clothing shops.

OligopolyA few large firms dominate the market, with high barriers to entry. Products may be identical (cement) or differentiated (mobile phone services). The key feature is interdependence: each firm's best decision depends on how its rivals will react.

Equilibrium under monopolistic competition

In the short run, a firm produces where MR = MC and can earn supernormal profit, like a small monopolist. Those profits attract new firms with similar products. Each existing firm loses some customers, so its demand (AR) curve shifts left and becomes more elastic. In the long run, entry stops when the AR curve just touches the ATC curve (tangency): P = ATC, so only normal profit is earned. But because the AR curve slopes down, the tangency is on the falling part of ATC, so firms produce below the lowest-cost output. This is excess capacity, and price is still above MC. The gain for consumers is variety and choice.

Oligopoly behaviour

The kinked demand curve model (Sweezy) explains why oligopoly prices tend to be rigid. If one firm raises its price, rivals do not follow, so it loses many customers: demand above the current price is elastic. If it cuts its price, rivals match the cut, so it gains few customers: demand below is inelastic. The kink creates a gap in the MR curve, so MC can move up or down within the gap without changing price or output. Oligopolists therefore prefer non-price competition (advertising, loyalty schemes, bundles). They may also collude in a cartel (formal) or follow a price leader (tacit); cartels such as OPEC in oil are the best-known case, though collusion is usually illegal under competition law.

Worked example: why oligopolists are tempted to cut prices

Problem

Two firms, A and B, each choose a high price or a low price. Monthly profits (Rs. million) are: both high → A 50, B 50; A low, B high → A 70, B 20; A high, B low → A 20, B 70; both low → A 30, B 30. What will they choose without an agreement?

Working

If B charges high: A earns 50 by charging high or 70 by charging low. Low is better for A.
If B charges low: A earns 20 by charging high or 30 by charging low. Low is better again.
So 'low' is A's dominant strategy (best whatever B does). By the same reasoning, it is B's dominant strategy too.
Outcome: both charge low and earn 30 each, although both charging high would give 50 each (a total of 100 instead of 60).

Answer

Both cut prices and earn Rs. 30 million each: the 'prisoners' dilemma'. This explains price wars, and why oligopolists are tempted to collude.

The four market structures compared

Feature	Perfect competition	Monopolistic competition	Oligopoly	Monopoly
Number of firms	Very many	Many	A few	One
Product	Identical	Differentiated	Identical or differentiated	Unique, no close substitute
Entry	Free	Free	Difficult	Blocked
Control over price	None (price taker)	Some	Considerable, but interdependent	Large (price maker)
Long-run profit	Normal	Normal	Often supernormal	Supernormal
Examples	Tea smallholders at auction	Restaurants, salons	Mobile telecom, cement	Electricity grid, piped water

In Sri Lankan business

Sri Lanka's mobile telecom market is an oligopoly: a few operators, such as Dialog and SLT-Mobitel, watch each other closely and compete mainly through data bundles, coverage and offers rather than open price wars. The many restaurants and bakeries in a town are monopolistic competition: each has a loyal following but no real power over the market price.

Exam angle

Short answer: “What is meant by interdependence in oligopoly?” Each firm's best decision on price or output depends on how its few rivals are expected to react.

Structured question: “Explain the kinked demand curve and why it leads to price rigidity.” Rivals ignore price rises (elastic upper part) but match cuts (inelastic lower part); the kink creates a gap in MR so cost changes within it leave price unchanged.

Essay: “Compare perfect competition, monopolistic competition, oligopoly and monopoly.” Compare number of firms, product, entry, price control, long-run profit and efficiency in a table, add a diagram for monopolistic competition's long run and the kinked demand curve, with Sri Lankan examples.

Remember it

Monopolistic competition = many brands, free entry, normal profit, excess capacity. Oligopoly = few firms, each watching the others (kink, collusion, non-price competition).